LN12: Time Value of Money

EEE 452: Engineering Economics and

Management
Md. Naqib Imtiaz Hussain

Ref: Chapter 4,5,7, Contemporary Engineering Economics by Chan S. Park

4th Edition and Wikipedia
 Outline: Time Value of Money
• What is Money?
– Functions
– Properties
– Supply
• Time value of money
– Concepts, PV, FPV
• Maths
What is money?
More money?
 Money
• Money is any item or verifiable record that is generally
accepted as payment for goods and services and repayment
of debts in a particular country or socio-economic context.
• The main functions of money are distinguished as: a medium
of exchange, a unit of account, a store of value and
sometimes, a standard of deferred payment.
• Any item or verifiable record that fulfills these functions can
be considered as money.
 Properties of Money
• Fungibility:
– its individual units must be capable of mutual substitution
(i.e., interchangeability).
• Durability:
– able to withstand repeated use.
• Portability:
– easily carried and transported.
• Cognizability:
– its value must be easily identified.
• Stability of value:
– its value should not fluctuate.
 Supply of Money
• Money is a broad term that refers to any financial
instrument that can fulfil the functions of money.
(definition of present day)
• These financial instruments together are collectively
referred to as the money supply of an economy
• Money supply data are recorded and published, usually
by the government or the central bank of the country.
Public and private sector analysts have long monitored
changes in the money supply because of the belief that
it affects the price level, inflation, the exchange rate
and the business cycle.
Bitcoin
 Time Value of Money
• You are given two option of receiving 1 crore
BDT: (a) Receive today, (b) Receive it after 2
years. Which one would you pick?

• How about receiving a 1 KG gold bar?

 Opportunity Cost of Delay
• Despite the equal value at the time of
disbursement, receiving money today has lot
more merit than receiving later.
• There is huge opportunity cost associated with
receiving it later.
• If money received early, it opens up possibility to
invest in business and generate profit. Cumulative
profit over 2 years can be significantly more than
the same value of money if received after 2 years.
 Some Basic Formula
• Present Value (PV) is the value at time= 0
• Future Value (FV) is the value at time = n
(months/years)
• Number of periods of time = n (integer/float)
• Profit rate (interest rate) at each period = I
Some Basic Formula
 Math 1
• Suppose you are offered the alternative of
receiving either $3,000 at the end of five years or
P dollars today. There is no question that the
$3,000 will be paid in full (no risk). Because you
have no current need for the money, you would
invest the P dollars in business that pays 8% or
more profit.
• What value of P would make you indifferent to
your choice between P dollars today and the
promise of $3,000 at the end of five years?
 Math 1: twist
• What if the early payment option gets
changed to:
– Half of the payment P is given now
– Other half of P is given after 1 year.
 Math 2
• Suppose that you are obtaining a personal
loan from your uncle in the amount of
$20,000 (now) to be repaid in two years to
cover some of your college expenses. If your
uncle usually earns minimum 8% profit
(annually) on his money, which is invested in
various sources, what minimum lump-sum
payment two years from now would make
your uncle happy?
 Math 2: Twist
• Uncle wants you to take up a part time
internship at a Tech company and
– (a) You pay yearly. How much should you pay each
year?
– (b) You pay every six months. How much should
you pay every six months?
 Math 3
• Suppose you are offered two options: (i)
receive Taka 30,000 at the end of 5 years or (ii)
receive Taka P today and another P after two
years. When you invest the Takas in business
that pays 8% or more profit yearly. What value
of P would be same as promise of Taka 30,000
to you after 5 years? Assume there is no risk in
this future payment.
 Math 4
• You inherited a huge mango garden in Rajshahi from a distantly
related great grandfather. It opens two choices for you:
• Choice (1): Farm for mango yourself and produce mango juice. You
will invest 300,000BDT to set it up. But at every year end you will
earn 600,000BDT (after deduction of all the taxes etc...) for the next
5 years.
• Choice (2): Lease out the garden to a company. It pays you
800,000BDT at the beginning of each year for the next 3 years. But
after that due to hyper production over natural limits your trees will
go barren for the next 2 years and production will become
negligible.
• Which option should you choose? Assume that yearly inflation rate
is 5%.